Two important tax treaty developments occurred over the course of the summer. The first was the public release on July 10th of the Technical Explanation to the fifth protocol (the Protocol) to the Canada-US Tax Convention (1980) (the US Treaty). The second was the approval by the Organisation for Economic Co-Operation and Development (the OECD) on July 18th of the contents of the 2008 update to the OECD Model Tax Convention.
Now is a particularly good time for taking stock of the Technical Explanation to the Protocol given that the US ratification process of the Protocol is almost completed. The Senate Foreign Relations Committee reported the Protocol favorably on July 29th, and the full US Senate ratified it on September 23rd. President Bush is expected to sign the US instrument of ratification very shortly. Canada had already ratified the Protocol on implementation of domestic legislation on December 14th, 2007. Once both contracting countries have provided formal notification, through diplomatic channels, that their applicable ratification procedures have been satisfied, the Protocol will come into force. While there has been no official announcement, it is expected that this will occur before the end of the year.
Technical Explanation to the Protocol
The public release of the Technical Explanation to the Protocol had been eagerly anticipated. The Technical Explanation is a document prepared by the Treasury Department as an official US guide to the Protocol. Because the document has been reviewed and accepted by the Canadian Department of Finance, it is considered a potentially valuable tool for interpreting the Protocol from a Canadian perspective.
In several cases, the Technical Explanation fulfills its promise and provides helpful explanations that clarify or expand on the language of the Protocol. However, in some cases, the Technical Explanation proposes interpretations not reflected in, or contradictory to, the actual wording of the Protocol ? raising questions about its persuasive value in those circumstances. Further, the Technical Explanation is either silent or unclear on other important interpretive issues.
This update highlights selected interpretive issues that have been addressed by the Technical Explanation, as well as issues that have remained unresolved. The focus of this update is primarily on the residence rules for fiscally transparent entities, the rules relating to dividends paid to fiscally transparent entities and the reciprocal limitation on benefits (LOB) provision. These rules will be described from the perspective of a resident of the US claiming benefits provided by Canada under the US Treaty.
Residence Rules for Fiscally Transparent Entities and Other Related Changes
Articles IV(6) and X(2)(a)
New Article IV(6) provides that Canadian-source income derived through an entity that is fiscally transparent for US tax purposes will be treated as "derived by" a US-resident member if the member is considered to derive such income through the entity for US tax purposes. Article IV(6) is intended not only to facilitate the treaty benefit claims of US-resident members of certain hybrid entities, such as US limited liability companies (LLCs), but also to codify the existing look-through approach used for partnerships not taxed as separate entities in the US, where treaty benefits are extended to the US-resident partners on the basis of their residence. Although Article IV(6) is designed to facilitate the treaty benefit claim of the US-resident member of the fiscally transparent entity, the actual entitlement to the particular benefit is still dependent on the member meeting other specific conditions specified in the US Treaty.
As an accompanying provision to Article IV(6), amended Article X(2)(a) is intended to facilitate the application of Article IV(6) to dividends paid to fiscally transparent entities by deeming a US-resident corporate member of a fiscally transparent entity to own the voting stock of a Canadian-resident dividend-paying company owned by the fiscally transparent entity in proportion to the US-resident corporate member’s proportionate ownership in the fiscally transparent entity. The ownership-deeming rule in Article X(2)(a) is needed to allow the US-resident corporate member (which has the requisite indirect interest in the Canadian-resident dividend-paying company) to gain access to the reduced 5 percent dividend withholding tax rate.
The Technical Explanation confirms that entities treated as fiscally transparent for US tax purposes include partnerships, common investment trusts, grantor trusts, US LLCs that are treated as partnerships or as disregarded entities for US tax purposes, and S corporations. When Canada is applying Article IV(6), it is clear that the determination of whether an entity is fiscally transparent will be based exclusively on its treatment for US tax purposes. This will be the case even when the entity is organized in a third country.
The Technical Explanation addresses the status of S corporations under Article IV(6). The Technical Explanation indicates that Canada will continue to provide the benefits of the US Treaty to an S corporation in its own right even though Canadian-source income derived through an S corporation may be considered derived by its US-resident shareholders pursuant to Article IV(6). The Technical Explanation aims at ensuring that any dividends paid by a Canadian-resident company of which the S corporation owns 10 percent of the voting stock could still benefit from the 5 percent withholding tax rate under Article X(2)(a) even though the individual shareholders, rather than the S corporation itself, are treated as deriving the dividend income paid by the Canadian-resident company under Article IV(6).
The Technical Explanation discusses the interaction of Article IV(6) with the determination of "beneficial ownership" for purposes of the US Treaty (including for the purposes of Articles X (dividends), XI (interest) and XII (royalties)). The Technical Explanation essentially provides for an independent treaty meaning of the concept of "beneficial owner" that applies in the case of fiscally transparent entities. More specifically, the Technical Explanation provides that the person who derives an item of income under Article IV(6) will necessarily be treated as the beneficial owner of the item of income for purposes of the US Treaty. The Technical Explanation aims at avoiding a potential mismatch in identity between the beneficial owner (if the concept took on its meaning under Canadian domestic law) and the person deriving the item of income in the case of a hybrid entity such as a US LLC.
The Technical Explanation provides some insight into how the "derived by" concept in Article IV(6) is meant to interact with provisions of the Income Tax Act (the Act). Even when Canadian-source income derived through a US LLC is considered derived by its US-resident members pursuant to Article IV(6), the Technical Explanation clarifies that the US LLC remains the only "visible" taxpayer for Canadian tax purposes and that the US-resident members of the US LLC will not be required to file Canadian tax returns in respect of income that benefits from Article IV(6). Instead, the US LLC itself will file a Canadian tax return in which it will claim the benefit of Article IV(6) and supply any documentation required to support the claim.
A number of interpretive issues are not addressed in the Technical Explanation. For example, the Technical Explanation does not provide any guidance as to how to apply the ownership-deeming rule in Article X(2)(a) in the context of a partnership. Since the release of the Protocol, Department of Finance officials have acknowledged that they do not yet have a position on whether the attribution of ownership through a general partnership under Article X(2)(a) should be based on income or capital entitlement or some other factor. They also have suggested that there may be issues in looking through limited partnerships where the limited partners are constrained from participating in management and are not entitled to participate in decisions with respect to the voting of the shares held by the limited partnership.
The Technical Explanation fails to address how Articles IV(6) and X(2)(a) apply to tiered structures involving a chain of fiscally transparent entities. It is not yet clear whether dividends paid through more than one tier of fiscally transparent entities qualify under the Protocol for the reduced withholding tax rate of 5 percent even when, on a look-through basis, 10 percent of the voting shares of the underlying Canadian-resident dividend paying company are attributable to the US-resident corporation.
The Technical Explanation is also silent on how Article IV(6) applies to triangular situations involving three different countries and the application of two different tax treaties to the same item of income. It would have been helpful if the Technical Explanation clarified that the principle of choosing the lower-taxing treaty necessarily applies on an item-by-item basis. Consider a situation where a US-resident company owns a Luxembourg société à responsabilité limitée (SARL) that is disregarded for US tax purposes, which in turn owns a Canadian company. Could interest paid by the Canadian company to the SARL be subject to the lower withholding tax rate under the US Treaty while a future gain on the disposition of the Canadian company by the SARL be subject to the broader relief provided by the capital gains provision under the Canada-Luxembourg Income Tax Convention?
Article IV(7)(b) provides that an amount of income, profit or gain will not be considered to be paid to or derived by a person who is a resident of the US where the person is considered for Canadian tax purposes to have received the amount from an entity that is a resident of Canada, but, by reason of the entity being treated as fiscally transparent for US tax purposes, the treatment of the amount for US tax purposes is not the same as its treatment would be if that entity were not treated as fiscally transparent for US tax purposes.
Article IV(7)(b) is clearly directed at unlimited liability companies (ULCs), since ULCs are the only type of entities that can, at the same time, be residents of Canada for Canadian tax purposes and be fiscally transparent for US tax purposes. Article IV(7)(b) is presumably introduced primarily to deny treaty benefits on interest payments made by a ULC to its US-resident shareholder as part of tax-efficient financing structures that would not have been caught by Article IV(7)(a), and certain debt pushdown structures that have recently been popular with US multinationals. On its face, however, the rule has a much wider scope.
The Technical Explanation does not attempt to narrow the scope of Article IV(7)(b). In fact, one example provided by the Technical Explanation assumes that Article IV(7)(b) applies to dividends paid by a ULC. Perhaps the reason that the Technical Explanation does not attempt to distinguish between abusive and non-abusive uses of ULCs is the existence of a consensus between Canada and the US that the overbreadth of Article IV(7)(b) can be effectively addressed only by amending it in a sixth protocol to the US Treaty.
The Technical Explanation fails to clarify whether payments made by a ULC to a US-resident shareholder are excluded from the application of Article IV(7)(b), and are therefore accorded treaty benefits, if they are part of a back-to-back arrangement pursuant to which the ULC first received the identical payment from an ordinary Canadian limited liability corporation.
The Protocol introduces new Article XXIX A, a reciprocal LOB article that imposes additional tests on residents of the US that generally determine whether they have a sufficient nexus with the US to claim benefits provided by Canada under the US Treaty.
Article XXIX A(1) states two general rules. The first is that only a "qualifying person" will be entitled to all of the benefits provided by Canada under the US Treaty. The second is that, except as provided in Articles XXIX A(3), (4), and (6), a person that is not a "qualifying person" will not be entitled to any benefits provided by Canada under the US Treaty.
Article XXIX A(2) describes categories of residents of the US that are entitled to all of the benefits provided by Canada under the US Treaty as a qualifying person.
Article XXIX A(3) provides that a resident of the US who is not a qualifying person under Article XXIX A(2) will nonetheless be eligible for benefits provided by Canada under the US Treaty with respect to an item of income derived from Canada if the person is engaged in the active conduct of a trade or business in the US, the item of income is connected with or incidental to the trade or business, and the trade or business is substantial in relation to the activities in Canada generating the income.
Article XXIX A(4) provides that a company resident in the US may qualify for the benefits provided by Canada under Articles X, XI, and XII if both an ownership test and a base erosion test are met. Article XXIX A(6) provides that benefits provided by Canada under the US Treaty may be granted if the Canadian competent authority determines that it is appropriate to provide benefits in a particular case.
Article XXIX A uses a number of undefined terms. One of the key interpretive issues is whether under Article III(2) of the US Treaty an undefined term should have the meaning it has under Canadian domestic law or whether it should be defined according to its context, which may include an independent treaty meaning given in the Technical Explanation.
The Technical Explanation provides that the US interpretation of "primarily traded" and "regularly traded" will be considered to apply, with such modifications as circumstances require, for the purposes of Canada applying the publicly traded test under Article XXIX A(2)(c), subject to the adoption by Canada of other definitions. Article XXIX A(2)(c) provides that a US-resident company or trust will be a qualifying person if its principal class of shares or units (and any disproportionate class of shares or units) is primarily and regularly traded on one or more recognized stock exchanges.
The Technical Explanation addresses the concern that the presence of a US LLC in the chain of ownership of a tested US-resident company could disqualify it from certain qualifying person tests. For instance, one of the conditions for a tested US-resident company to be a qualifying person under Article XXIX A(2)(d) is that each company and trust in the chain of ownership of the tested US-resident company also be a qualifying person. On its face, a US LLC cannot be a qualifying person because it is not considered to be a resident of the US. In this context, the Technical Explanation essentially provides that the principles in Article IV(6) are to be taken into account when applying the rules in Articles XXIX A(2)(d) and XXIX A(2)(e) so that one "looks through" fiscally transparent entities in the chain of ownership of the tested US-resident company.
The Technical Explanation does not attempt to define the scope of the term "directly or indirectly" used in the base erosion test under Article XXIX A(2)(e). This base erosion test requires that the amount of expenses paid or payable directly or indirectly by the tested US-resident company or trust to persons that are not qualifying persons and that are deductible in computing its gross income (as determined for US tax purposes) be less than 50 percent of the gross income of the tested US-resident company or trust. The use of the term "indirectly," without any qualification that its application is limited to deductible payments made through related parties, leaves open the question of whether it is necessary for a tested US-resident company or trust to trace its payments to an unrelated US-resident company or trust, so as to determine if the payments end up with a person that is not a qualifying person ? a clearly absurd result. In the absence of an independent treaty meaning, it would seem reasonable that the term "directly or indirectly" be interpreted according to its meaning under Canadian domestic law. For the purposes of subparagraph 95(2)(a)(ii) of the Act, the term "directly or indirectly" has been interpreted by the Canada Revenue Agency as requiring that the payment made by the initial payer be, in some manner, conditional on an equal payment being made to the ultimate payee.1
The Technical Explanation provides for a somewhat limited interpretation of the expression "derived in connection with" used in the active trade or business test under Article XXIX A(3). The Technical Explanation provides that income will be considered to be "derived in connection with" an active trade or business if the income-generating activity in the US is "upstream," "downstream," or parallel to that conducted in Canada. Interestingly, the Technical Explanation does not provide, as does the technical explanation to the 2006 US Model Convention, that an item of income will also be considered to be "derived in connection with" a trade or business when it is "complementary" to that trade or business. According to the 2006 US Model Convention, activities are considered complementary if they are part of the same overall industry and are related in the sense that the success or failure of one activity will tend to result in the success or failure of the other. The question becomes to what extent the more fulsome description of the expression "derived in connection with" found in the technical explanation to the US Model Convention could be used by Canada to interpret the corresponding term in Article XXIX A(3) of the US Treaty.
Other Provisions of the Protocol
Interpretive issues relating to other rules introduced by the Protocol that are not addressed by the Technical Explanation include the following:
- Under what circumstances, if any, does the use of a Canadian corporate subcontractor by a US enterprise give rise to a Canadian permanent establishment for the US enterprise under Article V(9)(b), the new rule under which certain services performed by a US enterprise results in a deemed Canadian permanent establishment?
- To what extent does paragraph 9 of Annex B of the Protocol, which provides the understanding of the two contracting countries with respect to the application of Article VII (business profits), incorporate by reference the so-called "authorized OECD approach" to attributing profits to a permanent establishment, given that the language of Article VII has remained substantially the same under the Protocol?
- Does Article XI(6), which makes certain contingent interest payments subject to the same 15 percent withholding tax rate applicable to "portfolio" dividends under Article X(2)(b), apply only to the portion of the interest on a debt obligation that is contingent or to the whole interest amount?
2008 Update to the OECD Model Tax Convention
On July 17, 2008, the OECD Council approved the contents of the 2008 update to the OECD Model Tax Convention (the 2008 update). The update was released as a discussion draft in April 2008.
The 2008 update includes at least three important developments that have resulted from past OECD reports.
First, the 2008 update introduces a mandatory arbitration procedure in Article 25 (competent authority). The details of the mandatory arbitration procedure are not prescribed in the OECD Model Tax Convention itself, but are left to an agreement between the competent authorities of the treaty countries. A proposed annex to the updated commentary to Article 25 contains a sample mutual agreement on arbitration that may be used and customized by the treaty countries. The proposed sample mutual agreement is similar, with certain important differences, to the new mandatory arbitration procedure introduced by the Protocol in new Articles XXVI(6) and XXVI(7) and Annex A of the US Treaty.
Second, the 2008 update contains important changes to the commentary on Article 5 (permanent establishment) relating to the treatment of services. In this new commentary to Article 5, a sample permanent establishment provision is proposed as an alternative to the general permanent establishment standard for countries disagreeing with the majority OECD position that the current provisions of Article 5 are appropriate to deal with cross-border services. This sample treaty provision is intended, essentially, to be a mechanism that countries may use to obtain more taxation rights with respect to cross-border services (when no permanent establishment exists under the traditional tests), but that still follows certain basic principles. With some departures in both language and substance, new Article V(9) of the US Treaty appears to be modeled after an earlier version of this sample treaty provision. Given that Canada was likely the party that requested the inclusion of Article V(9) in the US treaty, it will be interesting to see whether it decides to follow the OECD sample treaty provision or a provision that mimics Article V(9) of the US Treaty in its future tax treaty negotiations.
Third, the 2008 update includes changes to the commentary on Article 7 (business profits), which seeks to incorporate the aspects of the so-called "authorized OECD approach," as described in the December 2006 report on the attribution of profits to permanent establishments, that do not conflict with the existing commentary on Article 7. The purpose of the new commentary is to provide more certainty for the interpretation of existing treaties based on the current text of Article 7. As part of a two-track method for the implementation of the authorized OECD approach, the OECD also released on July 8th a public discussion draft of new Article 7 and accompanying changes to the commentary. It is anticipated that new Article 7 and the related commentary will be included in the next planned update of the OECD Model Tax Convention, tentatively scheduled for 2010, and will thereafter be used in the negotiation of future tax treaties and amendments to existing tax treaties.
Finally, the 2008 update includes technical changes to the commentary of the OECD Model Tax Convention that deal with, among other things, the residence of companies without a comprehensive tax liability, the concept of "place of effective management," dual-resident persons who are treaty non-residents under the tie-breaker rules, the definition of royalties, and whether days of residence should be taken into account for the purposes of the computation of the 183-day rule of Article 15 (income from employment).